There are both
opportunities and pitfalls for IRA owners, and while you definitely don’t want to
get caught up in a pitfall, you may want to take advantage of the
opportunities. IRAs come in two varieties: the traditional and the Roth. The traditional
generally provides a tax deduction for a contribution and tax-deferred
accumulation, with distributions being taxable. On the other hand, there is no
tax deduction for making a Roth contribution, but the distributions are
tax-free.

So, it leaves taxpayers with a significant decision, with long-term
consequences of whether to contribute to traditional or Roth IRA. If you can
afford to make the contributions without a tax deduction, then the Roth IRA is
probably the better choice in most circumstances. However, some high-income
restrictions limit the deductibility of a traditional IRA and the ability to contribute
to a Roth IRA.

Pitfalls – Here are some of the pitfalls that can be encountered with IRAs:

Early
withdrawals – IRAs were designed
by the government to be retirement resources, and to deter individuals from tapping
these accounts before retirement they added what is called an early withdrawal
penalty of 10% of the taxable amount of the IRA distribution. The penalty generally
applies for distributions made before reaching age 59-½, but there are some
exceptions to the penalty.

Excess
contributions – The tax code sets
the maximum amount that can be contributed to an IRA annually. Contributions in
excess of those limits are subject to a nondeductible 6% excise tax penalty,
and this penalty continues to apply each year until the over-contribution is
corrected.

Multiple
rollovers – A rollover is
where you take possession of the IRA funds for a period of time (up to 60 days)
and then redeposit the funds into the same or another IRA. Only one IRA rollover
is allowed in a 12-month period and all IRAs are treated as one for purposes of
this rule. If more than one rollover is made in a 12-month period, the
additional distributions are treated as taxable distributions and the rollover
is treated as an excess contribution, with both causing significant tax and
penalties. Rollovers can be avoided by directly transferring assets between IRA
trustees.

No Traditional IRA contributions in year reaching age 70½
–
Individuals cannot make a Traditional IRA contribution in the year they reach
the age 70½ or any year thereafter. This rule doesn’t apply to Roth IRAs. Contributions
to a traditional IRA made in the year you turn 70½ (and for subsequent years)
are treated as excess contributions and are subject to the nondeductible 6%
excise tax penalty until corrected.

Failing to take a required minimum distribution (RMD) – Individuals who have traditional IRA
accounts must begin taking RMDs in the year they turn 70½ and in each year
thereafter. However, the distribution for the year when an individual reaches
age 70½ can be delayed to the next year without penalty if the distribution is
made by April 1 of the next year. Failing to take a distribution is subject to
a penalty equal to 50% of the RMD. The IRS will generally waive the penalty for
non-willful failures to take the RMD, provided the individual has a valid
excuse and the under-distribution is corrected. The RMD rules don’t apply to
Roth IRAs while the owner is alive.

Opportunities

Late contributions – If you forgot to make an IRA
contribution or just decided to do so for the prior year, the tax law allows
you to make a retroactive contribution in the subsequent year, provided you do
so before the unextended April filing due date. As an example, you can make an
IRA contribution for 2018 through April 15, 2019. This is also a benefit for
taxpayers who were not previously sure they could afford to make a
contribution.

Switch the type of IRA – If you make an IRA contribution for a
year, tax law allows you to switch the designation of that contribution from a traditional
IRA to a Roth IRA, or vice versa, provided you do so before the unextended
April filing due date.

Backdoor Roth IRA – Contributing
to a Roth IRA is not allowed if the individual’s modified adjusted gross income
(AGI) exceeds a specified amount based on filing status. For example, the
limits for 2019 are $203,000 if filing a joint return, $10,000 if filing
married separate, or $137,000 for all others. If a high-income taxpayer would
like to contribute to a Roth IRA but cannot because of the income limitation,
there is a work-around that will allow the high-income individual to fund a
Roth IRA. Here is how that backdoor Roth IRA works:

First, a contribution is made to a traditional IRA. For higher-income taxpayers who participate in an employer-sponsored retirement plan, a traditional IRA is allowed but is not deductible. Even if all or some portion is deductible, the contribution can be designated as not deductible.

Then, since the law allows an individual to convert a traditional IRA to a Roth IRA without any income limitations, the non-deductible traditional IRA can be converted to a Roth IRA. Since the traditional IRA was non-deductible, the only tax related to the conversion would be on any appreciation in value of the traditional IRA before the conversion is completed.

One potential pitfall to the backdoor Roth IRA is
often overlooked by investment counselors and taxpayers alike that could result
in an unexpected taxable event upon conversion. For distribution or conversion
purposes, all of your IRAs (except Roth IRAs) are considered one account, and
any distribution or converted amounts are deemed taken ratably from the
deductible and non-deductible portions of the traditional IRA, and the portion
that comes from the deductible contributions would be taxable. So, the conversion
tax implications should be considered before employing the backdoor Roth
strategy.

Alimony as compensation – In order to contribute to an IRA, an individual must
receive “compensation.” For IRA purposes, compensation includes taxable alimony
received. Thus, for purposes of determining IRA contribution and
deduction limits, individuals who receive taxable alimony and separate
maintenance payments may treat the alimony as compensation, for purposes of
making either a traditional or a Roth contribution, allowing alimony recipients
to save for their retirement.

Spousal
IRA – One frequently overlooked tax benefit is the “spousal IRA.”
Generally, IRA contributions are only allowed for taxpayers who have
compensation (the term “compensation” includes wages, tips, bonuses,
professional fees, commissions, taxable alimony received, and net income from
self-employment). Spousal IRAs are the exception to that rule and allow a
non-working or low-earning spouse to contribute to his or her own IRA,
otherwise known as a spousal IRA, based upon his or her spouse’s compensation
(as long as it is enough to support the contribution).

Saver’s credit – The saver’s
credit, for low- to moderate-income taxpayers, helps offset part of the first
$2,000 an individual voluntarily contributes to an IRA or other retirement
plans. The saver’s credit is available in addition to any other tax savings resulting
from contributing to an IRA or retirement plans. Like other tax credits, the
saver’s credit can increase a taxpayer’s refund or reduce the tax owed. The
maximum saver’s credit is $1,000 ($2,000 for married couples if both spouses
contribute to a plan). The application of this credit is very limited. Please
call for additional details.

IRA-to-charity direct
transfers
– Individuals age 70½ or over must withdraw annual RMDs from their IRAs. These
folks can take advantage of a tax provision allowing taxpayers to transfer up
to $100,000 annually from their IRAs to qualified charities. This provision may
provide significant tax benefits, especially if you would be making a large
donation (although it also works for small amounts) to a charity anyway.

Here is how this provision, if utilized,
plays out on a tax return:

The IRA distribution is excluded
from income;

The distribution counts toward
the taxpayer’s RMD for the year; and

The distribution does NOT count
as a charitable contribution.

At first glance, this may not
appear to provide a tax benefit. However, by excluding the distribution, a
taxpayer with itemized deductions will lower his or her AGI, which will help with
other tax breaks (or punishments) that are pegged at AGI levels, such as
medical expenses, passive losses, and taxable Social Security income. In
addition, non-itemizers essentially receive the benefit of a charitable
contribution to offset the IRA distribution.

Please call this office for
further details or to schedule an appointment for some IRA planning unique to your
circumstances.